Financial Leverage – Explained + Examples
Financial leverage refers to the use of borrowed funds to increase the potential return on an investment. In other words, it’s the practice of using debt to amplify the profits or losses of an investment.
When an investor borrows money to make an investment, they are leveraging their investment. The goal of financial leverage is to use the borrowed money to generate a higher return on investment than the cost of the borrowed funds.
Financial leverage can be a powerful tool for investors when used correctly, as it can amplify their gains. However, it can also increase their losses if the investment doesn’t perform as expected.
A common example of financial leverage is buying a home with a mortgage. The homebuyer puts down a small percentage of the purchase price as a down payment and borrows the rest from a bank. If the value of the home goes up, the buyer can sell it for a profit and pay back the loan with interest, keeping the difference as a gain. However, if the value of the home goes down, the buyer still owes the loan, which could result in a loss.
Overall, financial leverage can be a useful tool for investors, but it is important to use it wisely and understand the potential risks involved.
Examples of financial leverage:
- Real estate: As mentioned earlier, buying a home with a mortgage is a common example of financial leverage. The homeowner puts down a small percentage of the purchase price and borrows the rest from a bank. If the value of the home goes up, the homeowner can sell it for a profit and pay back the loan with interest, keeping the difference as a gain.
- Stocks: Investors can use financial leverage to buy stocks on margin. This means they borrow money from a broker to buy stocks, with the hope of earning a higher return than the cost of borrowing the funds. However, if the stock price goes down, the investor can lose more than their initial investment.
- Business: Companies can use financial leverage by issuing bonds to raise money for expansion or other projects. By borrowing money, they can amplify their returns if their projects are successful. However, if the projects fail, they will still owe the debt, which can lead to financial distress.
- Private Equity: Private equity firms often use financial leverage to acquire companies. They borrow money to fund the purchase and hope to improve the company’s performance, increasing its value and paying off the debt with the profits.
- Personal finance: Taking out a personal loan to invest in a business or investment opportunity is another example of financial leverage. If the investment is successful, the investor can pay back the loan and keep the profits. However, if the investment fails, they will still owe the debt.